Seven rate hikes in 2022 an increasing possibility

• With the CPI hitting a 40 year high of 7.5%, the Fed has conceded that inflation is no longer transitory, and will likely begin raising rates in March. 

• Disruptions to the supply chain caused by COVID-19, along with robust consumer demand kept inflation high throughout the past few quarters. 

• Russia invading Ukraine added to inflationary pressures as food and energy costs soar. 

• Already way behind the curve, the Fed will have to tighten rates faster than expected. We project a total of 12 rate hikes from now till end 2023, which should bring the FFR to 3.25%.  

• Investors can mitigate the effect of rising rates by increasing exposure to financials, commodity related equities, markets with relatively lower valuations (e.g. China and Japan) and reduce the duration of their fixed income portfolios. 

“We see inflation as transitory” – Those were the words echoed by Federal Reserve Chairman Jerome Powell since the beginning of 2021 as consumer prices started rising along with economic activity in the US. 

In September, the first sign of trouble emerged when the leader of the central bank called inflation frustrating, noting that it was still sticking around longer than expected. Nonetheless he was still expecting inflation to ease eventually. 

Figure 1: US CPI is currently sitting at 7.5%, the highest in 40 years. 

Inflation unlikely to moderate significantly 

Initially, the Fed made the call that inflation was going to be transitory mainly because they thought that the pandemic-induced supply chain issues were the main culprit behind rising prices, and that these issues would eventually be resolved as the pandemic subsides. 

While this is true to a certain extent, putting an end to the pandemic has proven to be a tricky task as the US recorded its biggest surge in new COVID-19 cases since the beginning of the pandemic in January this year. With a sizeable chunk of the population out of action due to COVID-19, businesses within the country have to contend with a slew of challenges, ranging from logistics delays to labour shortages. 

Major US ports are currently suffering from the worst congestion in decades, partly due to a shortage of workers and truck drivers caused by the fast-spreading Omicron variant. In January, ports in Southern California (among the largest in the US) reported that roughly 10% of its daily workforce was unavailable due to COVID-19 related reasons. These factors, coupled with higher fuel costs and demand, sent freight rates up by nearly tenfold from pre-pandemic levels (Figure 2). 

Figure 2: Freight rates between China and the US have risen by as much as tenfold  

At the same time, the US economy is roaring back to life. Consumer spending is stronger than ever, thanks to the pent up demand, generous stimulus packages, and significant accumulation of savings over the course of the pandemic (Figure 3). Strong wage growth and rising home prices are also boosting household wealth, further fuelling the propensity to spend. 

Figure 3: Consumer spending in the US has already recovered beyond pre-pandemic levels 

Aside from soaring goods inflation, services inflation has also started to pick up – rising by 4.6% year-on year in January - the most in over 30 years. Shelter costs have increased by 4.4% year-on-year in January as rents and home prices in the US continue to rise (Figure 4). 

Throughout 2020, many renters were able to benefit from price reductions or even months of free rent – courtesy of the eviction moratorium and the emergency rental assistance program – as landlords struggled to fill empty units. These concessions, however, are more or less gone, and landlords are hiking rents as COVID-19 restrictions end and housing demand spikes.

Given that shelter costs account for nearly a third of the CPI basket and is more structural in nature, there is a high probability that inflation will remain elevated for the foreseeable future. 

Figure 4: US home prices and rents have risen sharply, adding to inflationary pressures

To make matters worse, Russia invaded Ukraine in late Feb, sending commodity prices from food to energy skyrocketing. Both countries are among the world’s largest grain exporters, while Russia is also a major energy exporter. As such, the conflict between both countries are likely to have an outsized impact on commodity markets.

With the Russia-Ukraine crisis deteriorating each day, we think that commodity prices are likely to remain elevated, or worse, go even higher from current levels, a development that will certainly add to inflationary pressures (Figure 5). 

Related Article: Our take on the Russia-Ukraine Crisis

Taken together, these trends point to the likelihood that inflation is no longer transitory, and will likely remain elevated for the foreseeable future. 

Figure 5: Commodity prices skyrocket as the Russia-Ukraine crisis escalates

Higher odds of more aggressive Fed tightening amid raging inflation 

Right now, markets are pricing in at least six rate hikes, which would bring the Fed Funds Rate (FFR) to 1.75% by early 2023. However, based on past rate hike cycles, it is observed that that the market has largely underestimated the actual number of rate hikes conducted by the Fed. This underestimation has ranged roughly between 1-2%. 

With inflation at the highest level in several decades and showing no signs of easing, we believe that there is a high probability that the Fed will tighten rates more aggressively than previously planned to tame inflation. 

To that end (under an aggressive tightening scenario), we project that there will be a total of 12 rate hikes between now and 2023, with seven of them occurring this year followed by five in the following year (Figure 6). This would bring the FFR to 3.25% by 2023. 

Figure 6: Fed Funds Rate projected to reach 3.25% by end 2023 

Unless inflation numbers come down sharply over the course of the year (a scenario which we think is unlikely given the current circumstances), investors should begin preparing their portfolios for a higher interest rate environment over the next two years. 

How should investors position themselves? 

In a rising rate environment, investors with growth heavy portfolios should consider diversifying their equity exposure to include more value oriented sectors, such as financials, which are likely to benefit in a rising rate environment. For exposure to the financial sector, investors can consider our recommended fund – the Blackrock World Financials Fund. 

Alternatively, they may also consider commodity-related equities as a hedge against inflation. With the Russia-Ukraine crisis threatening to disrupt Europe’s energy supply, energy commodity prices are likely to remain elevated. 

Secondly, with much of the world shifting towards clean energy, mining companies, especially those in the precious metals/base metals space may stand to benefit from this long-term trend towards sustainability. Our recommend fund for commodities exposure is the JPM Global Natural Resources Fund. Investors can also consider the Blackrock World Energy Fund.

Next, investors can also diversify their portfolio with exposure to markets that have attractive valuations, such as Japan, Asia ex-Japan, as well as China. Chinese equities, in particular, have been beaten down by a number of issues, such as the trade war and the crackdown on the tech sector, leaving their valuations at relatively more attractive levels than their peers. 

Monetary policy in China is also expected to be more accommodative, which should support its equity market. Our recommended products for Chinese equities include the iShares Core MSCI China ETF (HKEX:2801) and the JPM China A Fund. 

For Japan, investors may consider the JPM Japan Equity Fund or the iShares MSCI Japan ETF (NYSE:EWJ). 

In terms of single stock picks, investors should look to avoid highly leveraged companies as they may face difficulty refinancing their debt. Companies without pricing power (those who are unable to pass on the increased costs to consumers) should also be avoided. 

Lastly, for fixed income, investors should aim to reduce duration to protect against a faster than expected rate hike environment. Short duration bond funds, such as the Nikko AM Shenton Short Term Bond or the LionGlobal Short Duration Bond Cl A Acc SGD, are worth considering. 

While aggressive rate tightening policies generally lead to a period of lackluster equity returns, investors who position themselves well may find their portfolios performing better than the market.